What China's Yuan Plunge Means For Investors

The yuan is tanking again. Earlier this week, the Chinese currency hit a six-year low against the U.S. dollar, a continuation of a downtrend that began last year in August when the People's Bank of China abruptly changed its currency policy.

At that time, the PBoC reduced its daily reference rate by 1.9%―the largest one-day decline since 1994―setting off a panic in global financial markets about whether China's economy was slowing much faster than expected (the move was a precursor to the infamous Aug. 24, 2015 market swoon that sent U.S. stocks plunging more than 5% in a day).

The Chinese central bank said last year that the devaluation was a "one off" adjustment, but that clearly hasn't been the case as the yuan keeps falling. Today  one U.S. dollar is worth 6.72 yuan, compared with 6.39 yuan last August.

10-Year Yuan

In the chart above, the U.S. dollar is climbing against the Chinese yuan

Markets Brush Off Sinking Yuan

This time around, the sinking yuan hasn't made waves in broader financial markets like it did before. The S&P 500 is currently trading at 2,139, only 2% below its all-time high.

Even the impact on China-related ETFs has been relatively limited. The Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) is down 11.9% year-to-date―but it was down a heftier 25% in January.

The much more dismissive reaction on the part of financial markets to China's currency decline may simply have to do with perception.

Last August, and again this January, the predominant narrative was that China's economic growth was crashing and that the yuan devaluation was the Chinese government's desperate effort to prop up the struggling manufacturing industry.

For whatever reason, investors today are taking a more optimistic view of the situation in China. They're seeing the yuan's decline as a necessary adjustment in a world in which most currencies have plunged against the U.S. dollar.

Under this view, the yuan is merely mirroring the downward moves that other nondollar currencies have seen in the past few years, giving much-needed relief to Chinese exporters that were hindered by an artificially strong currency.

The Capital Flight Problem

That said, while the depreciating yuan certainly helps manufacturing and exports in China on the margin, the latest evidence suggests it may not be enough to support these ailing industries. China's exports tumbled 10% year-over-year in September, reigniting concerns about the health of the world's second-largest economy.

If sentiment on China begins to sour again, losses in the yuan could accelerate, exacerbating the ongoing capital flight problem. According to a Bloomberg gauge, about $1 trillion of capital has flowed out of China since last August as individuals and firms dump their yuan in anticipation of further losses in the currency.

To counter the exodus and help keep the yuan from plunging further, the PBoC has sold hundreds of billions of dollars of its foreign exchange reserves (the government's reserves now stand at $3.2 billion, down from $4 trillion at its peak).

China Foreign Exchange Reserves

Source: Bloomberg
 

But the PBoC's efforts have only slowed the bleeding. Its task has been made more difficult by the U.S. Fed, which has hinted that it may hike interest rates this December. That's pushed the U.S. dollar higher against currencies across the board, including the yuan.

With the Fed hike looming and with China's trade data deteriorating again, it's not hard to imagine a scenario in which capital outflows from the country surge, destabilizing the economy, while pushing the yuan and the country's foreign exchange reserves significantly lower. That could also lead to broader turmoil in global financial markets, much like was the case last August and this January.

That's why despite the current calm in global markets, investors shouldn't get complacent about China, at least until the yuan stabilizes and capital stops fleeing the country.

Contact Sumit Roy at [email protected]